The recession: How long, and how painful?

Deputy governor Christian Hawkesby hedges the Reserve Bank’s bets on what sort of downturn to expect next year,

The recession that the Reserve Bank is cooking up for next year could well be ‘‘short and sharp’’, rather than shallow, the bank’s deputy governor, Christian Hawkesby, says.

If anyone could make a recession sound attractive, it is probably Reserve Bank governor Adrian Orr.

Orr admitted to MPs on Thursday that the Reserve Bank intended to engineer a recession to reduce inflation, after raising the official cash rate to 4.25% and signalling it would rise to a previously-unexpected high of 5.5% next year.

The bank’s new forecast is that the economy will contract by 1% over the 12 months from April, and then flatline for another six months before returning to growth.

For comparison, the economy contracted much more severely, by about 2.7%, during the global financial crisis (GFC) and by just over 3% in the recession of 1991.

Orr has tried to make the economic medicine more palatable by highlighting the potential for a ‘‘job-rich slowdown’’ that doesn’t see people’s average standard of living drop below pre-Covid levels.

But Hawkesby says that while the bank’s ‘‘central view’’ is for 18 months of zero or negative growth, it could very well pan out much differently.

‘‘What we know from history, is that recessions do tend to be shorter and sharper.

‘‘They tend to happen over a couple of quarters. So we’re well aware that’s a possible outcome.’’

Year-long and shallow or short and sharp, Hawkesby says the only thing the bank knows for certain ‘‘is that the economy won’t pan out exactly like our projection’’.

Even so, the central bank’s message to the public is unambiguous; inflation is too high and people need to rein back their spending.

Any and all spending, that is. There aren’t any particular areas in which the Reserve Bank does or does not want to see economies, he says.

‘‘We are not going to get down to the level of people’s personal decisions; they’re going to have to make those tradeoffs themselves.

‘‘It’s just we need aggregate spending to come down.’’

A fire that could get out of control

Up until last week, ANZ had thought the tourism recovery would save the country from a technical recession.

But chief economist Sharon Zollner says the Reserve Bank’s hawkish monetary policy statement on Wednesday ‘‘felt different’’ and means ANZ will have to revisit its forecasts.

The central bank’s statement ‘‘had some deliberate ‘shock value’ that its other rate hikes just haven’t had’’, she says.

‘‘It did feel like the sort of thing that has the potential to cause more of a sudden stop in risk-taking, whether that’s employers hiring, or buying a house.’’

Factoring in the higher interest rates forecast by the Reserve Bank, ANZ would expect lower investment, lower consumption and ‘‘in particular a weaker housing market’’.

Zollner says it is clear the Reserve Bank is not trying to engineer a recession on the scale of that seen during the GFC or the early 1990s.

That doesn’t rule out the country getting one, she says.

The Reserve Bank forecasts house prices will fall another 10%, which would mean they would drop by 20% from their 2020 peak.

But Zollner describes the housing market as the country’s Achilles’ heel and says there is ‘‘absolutely a risk that in trying to singe the edges of the housing market the Reserve Bank could accidentally set it on fire’’.

There is also a risk that unemployment, which the Reserve Bank is tipping to peak at 5.7% in 2025, could ‘‘rise a lot more than the Reserve Bank is intending’’.

‘‘These ‘controlled landings’ don’t always end up fully controlled.’’

Council of Trade Unions economist Craig Renney also warns of the dangers of making too many assumptions at this stage.

The evidence doesn’t point to a GFC or 1990s-style recession, he says.

‘‘If it did happen it would be an external event – a big shock – that would likely drive that.’’

But it would be foolish to write-off anything now, he says.

‘‘A year ago, we were forecasting something very different. Two years ago, when Covid was coming in, we were forecasting 10% unemployment and the economy dropping like a stone.’’

Power in ‘your hands’

The type of recession we get, or even whether we get one at all, could depend on how the public responds to the Reserve Bank hitting the panic button on inflation.

Orr told MPs that power lay in the hands of the public, who could reduce the need for an economic contraction if they collectively cut their spending and assumed inflation would fall, for example when negotiating pay rises.

The more people reacted to the Reserve Bank’s changed tone by dialling down their spending and expectations of future inflation, the less pain the bank would need to inflict, he suggested.

But Zollner says it’s unclear what response the bank can expect to its appeal for austerity.

Much may depend on whether many people really start to worry about losing their jobs, she suggests.

A survey released by the Ministry of Business, Innovation and Employment last week found a record 53% of workers felt secure in their job and saw almost no chance they would lose their job or business over the next 12 months, she notes.

That could set the conditions for a game of chicken between the central bank and the public.

‘‘Telling people to spend less is worth a crack.’’

But Orr previously told people to ‘‘please make their wage and price decisions based on the Reserve Bank’s inflation forecasts rather than on current inflation’’ and they didn’t listen then, she says.

‘‘I’m not sure if they’ll listen, now.’’

The big doubt

None of what the Reserve Bank currently expects will necessarily come to pass.

What has spooked the bank is the persistence of high inflation and the concern that will become concreted into people’s future expectations.

‘‘One quarter of 7% inflation is quite different from a few quarters in a row of it hanging up there,’’ Orr said on Wednesday.

The bank is forecasting inflation will rise from its current level of 7.2% to peak at 7.5% in the December and March quarters and we will only know on January 25 whether its first forecast proves correct.

The big hope for borrowers is that the Reserve Bank has got its inflation forecasts materially wrong.

Renney doesn’t rule that out.

‘‘I can’t help but think that there’s a real possibility of inflation coming in lower than what is forecast now,’’ he says.

Hawkesby is unwilling to say much about how the bank might respond if Stats NZ were to report in January that inflation had fallen, instead of risen.

‘‘It would be put in the mix of everything else that were seeing,’’ he says.

‘‘What I would say is that inflation expectations are clearly critical to the outlook from here. The more that we get confidence that inflation expectations are coming back down to target at a pace we’re happy with, the more we can

‘‘We are not going to get down to the level of people’s personal decisions . . . It’s just we need aggregate spending to come down.’’

Christian Hawkesby

Deputy governor, Reserve Bank

get comfort that we’ve gone far enough.’’

A joker in the pack

Another factor that could determine how hard it gets next year is the response from the Government to any recession, noting that it will be an election year.

Eric Crampton, chief economist of the right-leaning New Zealand Initiative think-tank, says the Reserve Bank is ‘‘finally getting serious about trying to get inflation back in line’’ and believes the consequences will be felt widely and not just by borrowers.

‘‘It will have effects throughout the economy with investment projects not going ahead that don’t make sense under higher interest rates.’’

But he says the policy response to the Covid crisis, including the wage subsidy scheme, has encouraged thinking that governments can take a more active role in mitigating other problems more broadly.

‘‘I’m worried about a very volatile policy environment where a government that’s coming up for re-election and under pressure at the polls might be tempted to jump at the sort of policy measures that feel good in the short term, but can have substantial long-term costs,’’ he says.

Those could include ‘‘populist regulatory measures against businesses that are seen to have increased prices in times of high inflation’’, he says.

‘‘You can also imagine pressure for things like temporary rent freezes.’’

Investors pre-stressed for recession

Sharemarket investors appear to have taken the growing prospect of a recession and higher interest rates in their stride.

Bevan Graham, an economist with Salt Funds Management, believes the Reserve Bank’s monetary policy statement hasn’t materially changed the outlook for investors because there is ‘‘already a lot of bad news priced into markets’’.

‘‘We’ve long been of the view that the economy was looking at a recession in the middle part of next year.’’

The catalyst for change would be when investors started to see signs of inflation expectations cooling and a much anticipated ‘‘pivot’’ by central banks towards monetary easing, but that might not now happen until 2024, he says.

It is unlikely the Reserve Bank’s more hawkish stance greatly influences whether people choose to invest their money in New Zealand or overseas, he says.

‘‘There is a huge degree of synchronicity in economic cycles. All central banks are hiking interest rates and we’re all, relatively-speaking, in the same boat.’’

But there is a danger that the ongoing economic volatility could obscure investors’ view of structural changes that are taking places in economies, he says.

Looking beyond the likely recession in 2023, Salt is expecting a period of lower growth, higher inflation and higher interest rates.

‘‘I’m very dark on the outlook for productivity. I don’t necessarily think it gets any worse, but I just don’t see any hope of it getting significantly better.’’

China has completed its catch-up with the Western world with regard to productivity and now has a rapidly ageing population, he says.

‘‘This massive time period we’ve had when China has acted as the factory of the world and sent prices continually downward, is over.

‘‘That’s got significant implications for growth and inflation over the long term, not just next year.’’